A State-contingent Model for Applied Capital Budgeting: An Extension of the State-contingent Capital Budgeting Model by Banz & Miller

Knut Gaute Steen & Ilan Isak Hollander

Student thesis: Master thesis


This thesis develops a state-contingent capital budgeting model based on the model proposed in Banz and Miller (1978). The thesis aims at developing a theoretically consistent and empirically valid model, with clear relevance for applied capital budgeting. In contrast to the original Banz & Miller model, which uses a state-contingent risk-free rate to model state-contingent preferences, the proposed model uses state-contingent volatility. This is partially motivated by reduced estimation complexity and potential issues stemming from changed dynamics of real government bond yields due to quantitative easing. The thesis presents step-by-step derivations and estimations of the proposed model, in addition to its theoretical building blocks. The model builds on the Arrow-Debreu framework, the Black-Scholes-Merton framework and some theory of finite Markov chains. Furthermore, the thesis relates countercyclical volatility to newer and older research in the financial literature on topics such as the leverage effect, volatility feedback, liquidity spirals and time-varying risk aversion. The thesis investigates the proposed model’s applicability in real life valuation scenarios. A case study is conducted with the M&A department of the publicly listed Norwegian company Orkla. The case study reveals that the complexity of the model cannot be justified for all valuation purposes. On the other hand, the use of the model can be motivated by its ease of use in dynamic capital budgeting. The case study further reveals unrealistic assumptions in the proposed model, such as the absence of systematic risk within states of the market and nonincreasing systematic risk with time. To counter these issues, the thesis proposes two possible solutions, namely the certainty equivalent approach to valuation and a method of valuation using a non-recombining trinomial tree. The thesis concludes that the proposed model can be adapted to applied capital budgeting and that this can be done with relatively little compromise of theoretical consistency and empirical validity. However, a key criterion for the applicability of the model is that it is used for the right purposes. Furthermore, the presented extensions of the model may also be necessary.

EducationsMSc in Finance and Investments, (Graduate Programme) Final Thesis
Publication date2018
Number of pages128
SupervisorsKristian Miltersen